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PERFECTLY COMPETITIVE MARKET – A MODEL OF MARKET STRUCTURE

Updated on March 9, 2011

The structure of a market is a description of the behavior of buyers and sellers in the market. There may be many buyers, a few buyers or a single buyer. There may also be many sellers, a few sellers or a single seller. Where there are many buyers and sellers, there is competition and this type of market structure is called perfect competition or a Perfectly Competitive Market.

Perfect Competition is an economic model with which one can compare real situation. Economists believe that there are near perfect markets such as the stock exchange, the commodity market, foreign exchange market and others, but not completely perfect. A perfectly competitive firm faces a horizontal demand curve at the going market price. It is a price-taker. Any other type of firm faces a downward-sloping demand curve for its product and is called an imperfectly competitive firm. An imperfectly competitive firm cannot sell as much as it wants at the going market price but a perfectly competitive firm can.

PERFECT COMPETITION

A perfectly competitive market is one in which both buyers and sellers believe their own buying or selling decisions have no effect on the market price. The economist’s definition of perfect competition is different from the meaning of competition in every day usage. The economist means that each individual acts on the assumption that his action will have no effect on the market price, because the individual recognizes that his own quantities supplied and demanded are of little importance to the market as a whole in terms of quantum. The theory of market structure called perfect competition is built on the following assumptions.

ASSUMPTIONS OF /CHARACTERISTICS OF /CONDITIONS OF PERFECT COMPETITION

1) A large number relatively small sellers and buyers

If there are a large number of sellers relative to demand in the market, any one seller will know that, because he supplies so small a quantity of the total output, he can increase or decrease his output without having any significant effect on the market price of the product. The market price is taken as given and any quantity can be sold at that price. The seller is therefore described as a price taker. A firm in the perfectly competitive industry sells such a small proportion of the total market supply that it can double its output or halve it without affecting the market price.

2) Homogeneous product

The products of firms or sellers in a perfectly competitive market must be perfect substitute for that of another and purchase must be solely on the bases of price. This is to ensure that buyers do not care whom they buy from, as long as the price is the same. Without this condition, a producer with a slightly differentiated product can have some degree of control over the market. He may attempt changing output to influence price.

3) Perfect knowledge of the market conditions

Both producers and consumers are informed by the current market condition in terms of price, quality of the homogeneous product, supply and so on. With this assumption, any slight change in price would be known by both consumers and producers in no time. They will then react by changing the quantity. In particular, if there is an increase in price by a particular seller, consumers will get the commodity elsewhere. This is because there is perfect knowledge in the market and there are many producers of this homogeneous product. This firm will therefore not sell anything. At the existing price consumers, consumers will still purchase any quantity, therefore the rational producer will not reduce price. The average revenue (AR), marginal revenue (MR) and price (P) would be the same under perfect competition and would coincide with the perfectly elastic demand curve (horizontal demand curve). The reason is simple. Since price is fixed, the additional revenue that will be derived from the sale of an additional unit (marginal revenue) of the output will be equal to the price of the product. AR is the same as P. Therefore under perfect competition MR=P=AR. This can be understood clearly by table below. We can see from the table that MR=P=AR.

4) Free entry to and exit from the market

If the number of sellers is to remain large, there must be free entry to the industry, otherwise existing firms could combine to influence price or could grow in size as existing firms leave the industry. Free entry allows the profit motive to function. If demand increases causing price of the product to rise, the possibility of profits will attract other firms into that industry. Likewise, if the demand falls, losses sustained by some firms will cause them to leave the industry.

5) Perfect mobility of factors of production

A change in demand for a product in the long run must result in factors of production being transferred from one line of production to another. Moreover all factors, including entrepreneurship must be equally available to all firms.

As mentioned earlier, perfect competition is an economic model and real life situation can be compared with it. Perfect completion and monopoly are market structures that are not common. Monopoly is a market structure in which there is a sole producer or seller of a commodity that has no close substitute and the producer or seller has power to prevent entry. Most market structures lie somewhere in between these two. Imperfect competition is what prevails most and it embraces oligopoly and monopolistic competition. These shall be considered in subsequent writings.

Relationship Between Price (P), Marginal Revenue (MR), Total Revenue (TR) and Average Revenue (AR)

Quantity sold (Q)
Price (P)
Total Revenue (TR) = P.Q
Average Revenue(AR) = TR/Q
MR = dTR/dQ
1
$1000
$1000
$1000
 
2
$1000
$2000
$1000
$1000
3
$1000
$3000
$1000
$1000
4
$1000
$4000
$1000
$1000
5
$1000
$5000
$1000
$1000
6
$1000
$6000
$1000
$1000
7
$1000
$7000
$1000
$1000
8
$1000
$8000
$1000
$1000
9
$1000
$9000
$1000
$1000
10
$1000
$10000
$1000
$1000

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